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Tuesday, March 26th, 2013

How Do We Finance Walkable Neighborhoods? by Francisco Traverso

[ Francisco Traverso is a student who had as an assignment getting a paper he wrote published in a blog. I told him no guarantees but I'd give it consideration if he sent it since he had to write it anyway. He wrote it about Chris Leinberger's notion of "patient equity" which I haven't covered before, so I thought I'd go ahead and give it a post - Aaron. ]

A couple weeks ago, an article on the New York Times presented a new development near downtown Denver that is addressing health issues through design. The project is part of a larger development, La Alma/Lincoln Park Neighborhood that was conceived under Health Impact Assessment (HIA) principles. According to WHO, “HIA is a means of assessing the health impacts of policies, plans and projects in diverse economic sectors using quantitative, qualitative and participatory techniques. HIA helps decision-makers make choices about alternatives and improvements to prevent disease/injury and to actively promote health.” Among the various principles of HIA, better transit, cycling infrastructure, and walkable neighborhoods are primary components that foster a healthier lifestyle of residents of a certain area. However, at the very end, the article mentions something that is crucial for the success of initiatives like this: financing. As explained in the article, assessment advocates “anticipate that private developers will see the tool simply as a cost-adding measure or a way for community activists to stall or stop proposed projects.” What planners may offer as a solution to address health concerns of urban environments may be seen by others as barriers or may create unintended consequences for those creating the buildings that comprise the urban environments.

This is quite the dilemma. We like to think that planning professionals are the ones shaping our cities, where adequate policies will define the shape and quality of our built environment, but that is not entirely true. At some point someone has to face it, Real Estate Developers play a huge role in shaping our cities. As long as they play by the rules of regulation, everything else is acceptable, and so far, the results are not always what we would like to see in a walkable neighborhood.

So the question is: how do we engage developers in our plans of better, walkable neighborhoods?

The answer is not an easy one. Walkable developments are those where most of the amenities can be found in a 1500 feet radius from the project, and where inter-district transit may be used to expand the size of the district. This kind of development requires higher construction quality, have a complex permitting process, so they are more expensive and have higher financial risk than sub-urban development, so why investors interested in short term returns will be willing to invest in walkable neighborhood projects when the opposite of that is an alternative that provides cheaper land, cheaper construction costs and less risk?

There are probably many answers to this problem; however, there is one that is particularly interesting: Patient Equity.

In 2007, Christopher B. Leinberger published a paper where he discusses the importance of Patient Equity in Real Estate Development Finance and how more patient equity in walkable projects, from various sources and providers, would facilitate walkable development, and yield high returns over the long term (The definitions and examples provided in this post are extracted from Leinberger’s paper).

So what is Patient Equity and how does it work?

Patient equity is that part of the development financing structure that does not have a defined payback period. It is provided by either the long-term owners of a project or through government incentives that play a similar role.

Patient equity is not a substitute for other financing. Rather, it is additive, layered on top of a conventional development budget such that the overall cost of the project increases because of the higher construction costs and consulting costs associated to a project like this.

A development budget is comprised of equity and debt. Conventional equity, which often expects a 15 percent to 20 percent internal rate of return (IRR), has ownership of the project, provides the construction guarantee, and generally comprises approximately 20 percent of the total development budget. When patient equity is provided, the role of conventional equity changes and can be referred to as “1st tranche” equity, also called mezzanine debt. In exchange for having additional equity in the project (which is behind the 1st tranche equity in cash flow priority) and no financial guarantees of the construction loan (which the patient equity provides), 1st tranche equity will receive a lower rate of return and no ownership. Instead, the 1st tranche equity will receive 100 percent of the after-debt service cash flow until both the negotiated cumulative or non-cumulative rate of return is achieved and the principle is returned. It can be expected that 1st tranche equity is retired between years three and seven of the project’s life so the patient equity providers have to wait until then for financial returns.

With the retirement of the 1st tranche equity, 100 percent of the after-debt service cash flow of the project is available for the patient equity providers. It is the 2nd tranche investor that should have the long-term benefit of the project.  Among other benefits, patient equity investors in walkable projects are likely to see substantial financial returns as the project matures. There is an upward spiral of value creation as the critical mass of the walkable place is achieved and enhanced. As more development takes place within walking distance, there are more people on the street, which drives rents and sales prices up, resulting in land and building values going up, resulting in higher tax revenues and cash flow, so this is particularly important in urban settings that will undergo growth soon.

Sources of patient equity are many, and they include: Land, existing buildings in need of redevelopment, developer fees, parking, professional fees, and of course, cash. For example, professional fees can be deferred or traded for ownership in the project.

Who’s willing to provide patient equity? Land and building owners, developers, Pension Funds, Real Estate Investment Trusts, individual investors, non-profits, government. All these parties are trading present income, or short term income, for a long term income, that given the benefits of walkable neighborhoods described above will push for higher rents and higher land values in the long run, increment that doesn’t happen in the same amount in sub-urban development, where values tend to stay more stable in the long term.

Are these providers willing to “sell” the idea? Probably, and that’s the challenge, to get these people involved. Fortunately, there is at least one tool to engage them: Patient Equity.

8 Comments


8 Responses to “How Do We Finance Walkable Neighborhoods? by Francisco Traverso”

  1. Chris Barnett says:

    This is precisely why doing good community (re)development takes so long. Patient equity can come from any of a number of local or national “social capital” sources, and is often highly deal-specific. Some of it has housing-affordability strings attached, some of it preservation requirements, some is focused on job creation. All of it takes time to put together.

    Putting together these complicated deals is exactly what community development organizations (and their savvy for-profit development partners) do.

  2. George Mattei says:

    Interesting concept. I noted that Leinberger wrote his article in January of 2007. I wonder how the view of finance has changed since the real estate crash? Banks are surely still looking for a quick take-out, but long-term investors may be more willing to invest “patient equity” than they once were. Certainly we saw that the securitization of real estate debt, kind of a 3rd party patient equity, was burned. However, conversely we see many hedge funds taking longer-term stakes in housing through bulk-REO purchases and urban developments.

  3. George Mattei says:

    Chris, I work for what is more or less a community development organization, and I am plugged into the industry in Ohio. Perhaps it’s different elsewhere, but I can say that there’s not much more than fairly small-scale long-term approaches being developed. This issue is that many non-profit community development organizations don’t have the capital to engage in long-term buy-and –hold strategies to accumulate a critical mass in these communities. Virtually all government sources have deadlines, making it difficult to use them to accumulate a critical mass of properties.

  4. Chris Barnett says:

    George, I do understand a CDO lacking capital to independently do a big deal. Firsthand.

    There’s nothing wrong with smaller projects being tackled as long as it’s part of an overall area plan. My read is that large-scale, all-at-once redevelopment is capital-efficient but not particularly human-friendly, and smaller-scale is better in terms of activity and real place-making. It also doesn’t engender as much NIMBYism.

    Here I channel Jane Jacobs and Holly Whyte: superblocks (residential or commercial) aren’t human places, human scaled, or highly differentiated in ways that make an interesting place. They tend to be exceedingly pro-forma driven, and thus overly gentrifying influences. In a city like Indy, superblocks don’t have any $6-15/foot (here, that’s class B & C) ground floor space for independent start-up retail/commercial. In Columbus, it yields something like the Nationwide corporate/arena/convention center complex or the now-demolished downtown mall instead of Short North or German Village or Main Street Bexley.

    Larger-scale (superblock) redevelopment can also lead to Disney-esque places featuring a small-scale facade but no real diversity. To make the rent, store or restaurant prices still have to be in the gentrified range whether it’s knick-knacks, services, clothes, or food. Hello $12 burgers, $79 hoodies, and $30 haircuts. (My frame of reference is not megapolitan cities, but Midwestern.)

    My idea of “large scale” is just what you seem to point out: serial reinvestment in a bunch of individual buildings in a tightly defined place, some of it fully financed with private money, with the more challenging ones done with patient capital.

    There is a sweet spot for the government/patient capital in this realm: it can fill gaps efficently in smaller “problem” (re)developments. CDO’s can do smaller projects, earn development fees to sustain their overhead, and hold low-cash-flow property for a while.

    I think this is a viable and useful way to preserve/enhance the essence of place without instant gentrification. It allows the easy, small market-rate projects to proceed without assembling huge tracts and big piles of capital; small-scale entrepreneur-developers are a little more secure knowing that the difficult/problem properties are also being addressed.

  5. This seems like a credible and not-too-convoluted back-door approach to financing something that, from an urbanist’s angle, is an “absolute good”, but often escapes new developments because the IRR does not manifest itself quickly (as leasing an apartment would) and it is difficult to articulate the benefit to potential equity partners. Walkability often falls through cracks unless legislators shoehorn it in, which usually only repels development. Aside from mandating universal design or complete streets (two specious “shoehorn” methods with both pros and serious deficiencies), another urban design basic that often repels the more risk-averse developers is street level retail. Few neighborhoods are worse off with differentiated storefronts; these days only the most ardent NIMBYs disapprove. But because the country is already obscenely overbuilt with retail (much of it terribly designed), it is hard to impel the developer of even a medium-to-high density residential project to saturate that street level with big windows and commercial uses.

    Perhaps patient equity would address this mismatch, giving the new project what it needs in terms of promoting neighborhood walkability, without policies forcing it onto developers and inadvertently turning them off. Then again, as Chris observes, it probably works best in superblock mega-projects, which inevitably lack Jane Jacobs’ architectural differentiation–and always lack diversity of age–creating the sort of “Disneyfied” results that date themselves badly and rarely become “cool” again, thereby suffering obsolescence way too quickly. Small or medium projects are probably best for attempting this financing approach, yet they lack the tranformative effect that endows the patient equity approach with credible long-term payoff.

  6. This seems like a credible and not-too-convoluted back-door approach to financing something that, from an urbanist’s angle, is an “absolute good”, but often escapes new developments because the IRR does not manifest itself quickly (as leasing an apartment would) and it is difficult to articulate the benefit to potential equity partners. Walkability often falls through cracks unless legislators shoehorn it in, which usually only repels development. Aside from mandating universal design or complete streets (two specious “shoehorn” methods with both pros and serious deficiencies), another urban design basic that often repels the more risk-averse developers is street level retail. Few neighborhoods are worse off with differentiated storefronts; these days only the most ardent NIMBYs disapprove. But because the country is already obscenely overbuilt with retail (much of it terribly designed), it is hard to impel the developer of even a medium-to-high density residential project to saturate that street level with big windows and commercial uses.

    Perhaps patient equity would address this mismatch, giving the new project what it needs in terms of promoting neighborhood walkability, without policies forcing it onto developers and inadvertently turning them off. Then again, as Chris observes, it probably works best in superblock mega-projects, which inevitably lack Jane Jacobs’ architectural differentiation–and always lack diversity of age–creating the sort of “Disneyfied” results that date themselves badly and rarely become “cool” again, thereby suffering obsolescence way too quickly. Small or medium projects are probably best for attempting this financing approach, yet they lack the transformative effect that endows the patient equity approach with credible long-term payoff.

  7. George Mattei says:

    Maybe the market is changing. Here in Columbus, a major local player in the development field, Robert Weiler, agreed to invest equity in a downtown development to build about 250 apartments with ground-floor retail next to the new Columbus Commons park (where that old mall used to be). Carter, a large out-of-town developer was looking for a local equity partner, and Weiler had avoided downtown in the past. He stated his main concern had been that commercial space would sit vacant, pulling the development down with it. The fact that he became an equity partner (perhaps a patient equity partner?) shows how views are changing for this type of development.

  8. Chris Barnett says:

    In my experience, the “patient equity” in an urban deal is often some governmental (a redevelopment authority or even City CDBG money) or charitable entity, and their mezzanine or 2nd-place investment is what brings the for-profit developer’s return up to the level s/he expects in a suburb or exurb to make the project feasible.

    I’ll go a step beyond what Eric McAfee wrote above: when we are already obscenely “over-retailed”, I am not sure urbanists should be pushing so hard to make the whole ground floor of every new building into retail space. I don’t see as big an issue with a mix of office, retail/commercial and residential.

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